Mental Accounting

Have you ever fantasized about winning the lottery? Have you ever spent time daydreaming and mentally spending every dime that you won and then restarted from the beginning and spent it all again? I, for one, have done this so many times. I feel euphoric as I pretend to pay off my house, then my student loans and credit card debt, pay off my siblings' homes, send some money to charity, purchase a farmhouse where my kids have their own room and bank the rest. Then I'll ponder some more, rethink the allocations and start from scratch. It's fun (as long as you keep your feet firmly grounded in reality) to let your imagination run wild and spend your fantasy winnings.

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What about real money? With the beginning of the New Year brings the task of gathering our receipts and credit card statements and beginning to prepare our tax returns. For some of us, that means a tax return and the promise of some money in our pockets to either, save, spend, pay off debt or do with it whatever we choose. You're probably already thinking about it, aren't you? How many times have you designated it to different areas in your mind only to hit the delete button and start all over again? Laura Rowley, a Financial Expert with Yahoo! Finance calls this process "Mental Accounting" and defines it as "the way people separate different pools of money in their heads in ways that are both rational and irrational."

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Let's assume that I get a $2,000 tax refund (according to USA Today, the average tax return was $3,036 in 2009). Rational thinking would tell me to use that money to wipe out my credit card debt entirely and save myself an average of 21% in interest payments. Then I think, "Hey, wait! What if I took $500 and put it toward my debt, put another $500 into my savings and spent the remaining $1,000 on a trip?" I can tell you this; I will reallocate that pool of money probably fifty more times before it actually lands in my hands. It's going to take discipline, guidance from Laura Rowley and lots of encouragement for me to ensure that I'm doing the right thing with the right amounts.

Mental accounting can be tricky because you can potentially think yourself sideways and then be even more befuddled than when you started. Isn't it good, though, to really put yourself through a thoughtful process of trying to do the best thing for yourself and your family? Should I use that money toward my children's savings accounts and pretend I never had it? Should I start a certificate of deposit or use it to buy stocks and take my chances? I can tell you this: I will think, think again and rethink some more before I spend.